An extremist, not a fanatic

February 28, 2015

What failure of macroeconomics?

I'm in two minds about Frances' critique of macroeconomics. A bit of me disagrees, but a bit thinks she might be understating the problem.

First, a disagreement. In one respect, the 2008 crisis actually strengthened economics. The investor who followed the sell in May rule, or who used foreign buying of US equities as a sell signal, would have been out of equities before the crash of 2008. In this sense, the financial crisis actually vindicated the claim that economists can fulfill the useful function of warning of trouble ahead.

Of course, these two guides told us nothing about the causes of the crisis. But we must remember Jon Elster's words:

Sometimes we can explain without being able to predict, and sometimes predict without being able to explain. (Nuts and Bolts for the Social Sciences, p8)

I also disagree with this:

The failure of most macroeconomists to foresee the financial crisis grew out of their incorrect understanding of how money is created, and perhaps more importantly, how leverage builds up.

However, most banks didn't fail merely because their debts turned bad. They did so because of bad takeovers (eg RBS-Amro or Lloyds-HBOS) and/or a reliance upon wholesale finance. These were not so much macroeconomic failures as micro ones - bad decisions by individual businesses*. As the TSC said (pdf):

The origins of the banking crisis were many and varied, including low real interest rates, a search for yield, apparent excess liquidity and a misplaced faith in financial innovation. These ingredients combined to create an environment rich in over-confidence, over-optimism and the stifling of contrary opinions.

In this sense, the bank crisis was an example of what Xavier Gabaix called the "granular" origin of aggregate fluctuations. Recessions can result from the failure of individual firms.

What matters here is the structure of economic networks: see for example this paper by Daron Acemoglu and these papers in the JEP. Bank failures matter because banks are key hubs, in three different senses:

- Banks emulate each others' strategies. As Frances says, they herd. The failure of one is therefore likely to be correlated with the failure of others.

- One bank's failure will have a chilling effect on others; they'll try to hoard cash by withdrawing credit.

- Non-financial firms can't easily switch away from bank finance. As an empirical matter, private equity, P2P lending, crowdfunding and suchlike were not sufficient to replace lost bank credit. For this reason, the collapse of RBS was not like the demise of Woolworths. People could easily get their pick n mix elsewhere; they couldn't so easily get finance elsewhere. For this reason the collapse of banks had horrible macroeconomic effects.

It's for this reason that I say Frances understates the problem. The flaw with representative agent models isn't that they ignored the financial sector or that they forgot that "expectations are driven as much by emotion as logic." These problems are fixable. The problem is that recessions sometimes arise from interactions between firms and from firms position within networks; the failure of a hub matters whereas the failure of a spoke doesn't. Representative agent models, by definition, omit this. To this extent, we need a different paradigm. And perhaps this paradigm will only ever allow us to understand events after the fact rather than predict them.

We must, however, remember something else. Even if we had a fantastic macroeconomic theory, there is no guarantee whatsoever that governments will use it for policy purposes. As Simon says, we have a perfectly good theory of what fiscal policy should be at the ZLB - and it is being ignored.

Explanation and prediction are two different things. And good policy is a third different thing.

* Caveat: a current account deficit means that domestic investment exceeds domestic saving. This implies that domestic banks' lending might well be rising faster than deposits, implying a reliance upon other sources of funding.

Yes, you are right about the causes of the bank failures. But I did not say the failure of macroeconomists to foresee the crisis caused these failures! I said that macroeconomists did not generally foresee the crisis because they did not understand how banks work. In particular, they did not understand how the endogenous creation of credit money in a highly interconnected global financial system can under some circumstances form dangerously unstable feedback loops, especially when it is associated with expectations of rising collateral values. That, I think, is substantially correct.

It's a little too simple to blame reliance on wholesale finance for banks' funding pressures. The substantive cause of the funding market disruption during 2007-8 was sharply falling collateral values: for example, the inability to price collateral was the reason for the BNP Paribas fund closures that triggered the 2007 ABCP run that killed Northern Rock. In other words, banks struggled to fund themselves because their assets were turning bad.

I agree completely with your comments about the need for a new paradigm. If we can't even identify network hubs, let alone map the correlations and interdependencies within the system, how can we possibly protect against the consequences of traumatic hub failure?

I would however add that we also need to pay attention to the tendency of a complex and chaotic system (in the scientific sense) to form unstable feedback loops. Storms, if you like.

Recent bank failures are portrayed by Chris and Frances as if there’s somethIng unusual about bank failures. It’s about time we cottoned onto the fact that banks have been failing regular as clockwork ever since banks were invented.

They failed by their hundreds in the 1930s in the US and depositors lost $6bn. That’s very roughly £60bn in today’s money. They failed over and over in the 1800s. Between 1970 and 2000 several large UK banks were technically insolvent according to Robert Peston.

As for Chris’s claim that banks failed because of “bad takeovers”, presumably if those takeovers had not taken place, then the takeover target banks would have failed.

Under the present bank set up, a bank is an entity whose liabilities are fixed in value and whose assets can fall in value (to below the value of the liabilities). That’s just asking for trouble, and trouble is what it brings.

Banks under the present set up are entities which are FUNDAMENTALLY FLAWED.

I don't get the connection between crisis and money creation and ibdont think the alleged misunderstandings of how banks create money are nearly as important as critics make out.

Mainstream macro was never in the business of trying to predict crises it was all about how to react to them

I think the failure was sheer complacency. They trusted banks to know what they were doing. Economists understood perfectly well how banks can fail if they hold bad quality assets, have their solvency called into question so interbank lending shuts down, reliance on wholesale finance, the dynamics of asset firesales and all the other stuff that happened. All this stuff was well understood, it was just nobody was paying attention, nobody thought it would happen to supposedly sophisticated banks, nobody was following what was happening in shadow banking, and so on and so forth.

I've never really understood why the locus of criticism was mainstream macro, which was never concerned with these things. It's a fair criticism the mainstream was looking in the wrong direction, but I honestly did not think that anything happened that was not already well understood by those parts of economics that actually studied finance and crises, although I think you're right that models of network stability were languishing in obscurity

OK Allan maybe you can explain why financial economists who concerned themselves with studying the financial system attracted hardly any opprobrium whilst the bunch who were busy studying how to stabalise economies in the wake of shocks got all the flack, and maybe you can tell me what happened during the financial crisis that was not already understood ?

I put that badly. I'm sure some elements were not already well understood, I more meant that the main ingredients of a financial crisis were well understood. Mostly ignored by mainstream macro, bit that's a different matter.

After the crisis hit, lots of mainstream finance economists wrote excellent papers explaining what happened.

The criticism, I think, ought to be that these guys did don't think it could happen here, before it did

Luis Enrique;
" I more meant that the main ingredients of a financial crisis were well understood. Mostly ignored by mainstream macro, bit that's a different matter."

No, it's the whole 'matter' of this post because of what Coppola wrote and Dillow decided to comment upon it. It's remarks like this by you that create the impression of someone failing to grasp things accurately.

"The criticism, I think, ought to be that these guys did don't think it could happen here, before it did "

Sigh. This is what the criticism contained in Coppola's piece IS, you maroon. Mainstream macros' arrogance in relying on their 'sophisticated' models was exposed precisely because they predicted 'this can't happen'.

I apologise to all other readers for making this comment towards Luis Enrique rather than impersonally.

You ask a good question, namely what’s the connection between bank crises and money creation. My answer, which I actually alluded to above, is thus.

If the commercial bank system can create money out of thin air, and that money is loaned out to mortgagors, businesses, etc, commercial banks’ liabilities then consist of MONEY, which is stuff that is fixed in value (apart from inflation), and they have assets which can fall dramatically in value (loans to Irish and Spanish property developers being a recent example). That’s asking for trouble.

An alternative and I think better system is one where just the state creates / prints money. As to banks which lend, they are funded by SHARES, and in that case it’s impossible for them to go insolvent. And as to people who want a totally safe mode of lodging money, they’re catered for by accounts or entities that only invest in ultra safe stuff: base money and/or short term government debt. In fact National Savings and Investments already performs the latter function, more or less.

That’s called “full reserve” banking and it’s a system that is being imposed on money market mutual funds in the US. See:

Whenever I read Jon Elster's name I remember he spent years working on a formalist Marxism; that he's a political theorist who works in a philosophy department while referring to himself as a scientist.

"Sometimes we can explain without being able to predict, and sometimes predict without being able to explain."

It was a bubble; the end was predictable and predicted.

"Banks emulate each others' strategies. As Frances says, they herd. The failure of one is therefore likely to be correlated with the failure of others."

People emulate each others' strategies. They herd. The failure of one is therefore likely to be correlated with the failure of others.
People are more predictable than rational.

My remarks may have been unpleasant to you but they are in no way stupid, inaccurate or incorrect. And they were made after taking pains to understand what you are saying: with a lot more effect, I might suggest, than you regularly achieve.

The first. We are used to seeing macroeconomists, who ignored banking, get flack. And rightly so. But those economists who actually study banking - perhaps you are not aware these even exist - seem to get a pass. I don't understand why. You haven't explained why that's worthy of your derision,

The second evidently needs some expanding one. We are used to reading that macroecomists had nothing useful to say about financial crises. I claim that economics contained that what you needed to understand what happened (although not within macroeconomics). This is a modification of the usual critique, which often overlooks that or even denies it. You say nothing about that. You take me to be saying something I was not. My point is certainly not a defence of macroeconomists - spending all your time worrying about how to deal with earthquakes when you are just about to be hit by a comet is a major failing. But the failings of macroeconomcs are a different matter - as in, a different point - to the one I was making, and which you missed. And when I say that those actual financial economists - as opposed to macroeconomists - who I suggest deserve more blame than they get - were only wise with hindsight, I certainly don't imagine that I am saying anything Chris or Francis would disagree with, although I don't think that was quite the point they were making, at least Francis is I think more concerned with the failings of macro.

Re-reading your comments it's not obvious you have even picked up the distinction I was making between macro, and financial economics.

More on-topic: the failure of Woolworths was a direct example of the kind of failure that bankers and financiers failed to spot. The business had been unviable for years (recorded music was the only profitable part keeping the weird-discount-store model afloat), but was able to access vast quantities of cheap money during the boom based on poor due diligence by all concerned.

Anyone visiting a shop, or looking at their trading records, would know that it added no value and would have been better closed down, but there was no incentive for people to do so for as long as financial engineering could keep it going.

I read an article from the 1930s that pointed out that banks had always been failing on a regular basis. That included all through the 1920s, the period for which they presented statistics. The primary cause of bank failure, the reporters at Fortune argued, was that most banks were small and subject to buying into garbage investments specially packaged to look pretty. The typical small town or even small city bank executive was considered an easy mark for a certain class of financial operator, so, after a few rounds of golf, the bank would buy into some such scheme or another and in short order find itself up the creek.

The reporters argued that a lot of the problem was the lack of financial sophistication on the part of the typical bank officers in the face of big city financial operators and their sleaze bag traveling sales teams. The newly formed FDIC was to eliminate or at least isolate the negative effects of this lack of - well, call it what you will. Amusingly, the most recent financial crisis was not all that different, though I think willful credulity played a greater role. It is easier to imagine the president of the Bank of Smithtown, population 30,000, buying into some obviously bogus investment, than the president of, let us say, Citibank.

"People emulate each others' strategies. They herd. The failure of one is therefore likely to be correlated with the failure of others.
People are more predictable than rational."

That's it, in a nutshell @seth edenbaum.

People cluster and follow each other. But macroeconomic models :

a) are either grounded in the assumption that people's behaviour is a kind of "noise" so that their various ups and downs cancel each other out rather than getting reinforced and amplified.

b) even when they do recognize herding, have very, very poor models indeed of how this copying is structured, how failures spread epidemiologically through the economy. THIS is what macroeconomists should be taken to task for. They claim they have valid models of the large-scale workings of the economy, but actually miss the hugely important questions of structure / topology and the positive feedback loops amplifying trends. So much so that their models are effectively blind when these forces overturn the economy and cause crashes.

The whole post is absurd. Basic economics called the bubble years before it popped, but basic economics was ignored because it's boring. And risk is exiting! None of the discussion here has anything to do with questions of government policy and the public good. The people who called the bubble don't need grand theories. Banality is enough to make general predictions.

The discussion is made for lovers of abstraction, and for people who want to jump in the bubble and know when to get out. It's theory for high stakes gamblers who want to gamble with other people's lives. Bubbles are sexy!

Technocrats never want to admit that all words in use have subtexts. They're like junkies who say they can quit.
Men who get hard-ons predicting the behavior of the mediocre, are mediocre men.